A Guide to GAAP
[Submitted by CA S. Ramaswamy,
May 21, 2023
GAAP is the abbreviation for “Generally Accepted Accounting Principles”. Basically, they are the US Accounting Standards.
What Is GAAP?
GAAP is a set of detailed accounting guidelines and standards meant to ensure publicly traded U.S. companies are compiling and reporting clear and consistent financial information in a standardized manner.
GAAP is published by the Financial Accounting Standards Board (FASB). It is the U.S. equivalent of the International Financial Reporting Standards (IFRS).
Though only regulated and publicly traded businesses are legally obligated to follow GAAP, it is preferred that private companies also follow the rules in the presentation of their financial statements.
All Publicly traded companies in the U.S. must be GAAP compliant. The financial statements of these companies must follow all the GAAP principles and meet GAAP standards. If a company is found violating GAAP principles, there are many adverse consequences ranging from large monetary fines to significant negative impacts on credibility of the company.
GAAP vs. IFRS
GAAP is a U.S.-based set of standards. Outside the U.S., the most commonly used accounting regulations are known as the International Financial Reporting Standards (IFRS). The IFRS is used in over 100 countries, including countries in the European Union, Japan, Australia and Canada. Even Indian Accounting and Auditing standards are based on IFRS.
10 Key Principles of GAAP
The core of GAAP revolves around a list of ten principles. Together, these principles are meant to clearly define, standardize and regulate the reporting of a company’s financial information and to prevent tampering of data or unethical practices.
1. Principle of Regularity
GAAP must always be followed by accountants and businesses when handling financial information. At no point can a company or financial team choose to ignore or modify any of the regulations.
2. Principle of Consistency
Accountants are responsible for using the same standards and practices for all accounting periods. If a method or practice is changed, or if you hire a new accountant with a different system, the change must be fully documented and justified in the footnotes of the financial statements. This principle ensures that any company’s internal financial documentation is consistent over time.
3. Principle of Sincerity
This principle states that any accountant or accounting team hired by a company is obligated to provide the most unbiased, accurate financial report possible. Although a business may be in a bad financial situation, one that may even compromise its future, the accountant may only report on the situation as it is.
4. Principle of Permanence of Methods
This principle requires accountants to use the same reporting method procedures across all the financial statements prepared. Though it is similar to the second principle, it narrows in specifically on financial reports—ensuring any report prepared by one company can be easily compared to one another.
5. Principle of Non-Compensation
All negative and positive values on a financial statement, regardless of how they reflect upon the company, must be clearly reported by the accounting team. Accountants cannot try to make things look better by compensating a debt with an asset or an expense with revenue.
6. Principle of Prudence
Formally reported data must be fact-based and dependent on clear, concrete numbers. It’s easy to start wandering into speculation when you talk about finance—especially when thinking about the future of the company—and this principle makes sure to keep accountants firmly grounded in reality. Businesses can still engage in speculation and forecasting, of course, but they cannot add this information to formal financial statements.
7. Principle of Continuity
When compiling reports, accountants must assume a business will continue to operate. The principle applies regardless of the status of the company.
8. Principle of Periodicity
Essentially, this principle requires accountants to report financial information only in the relevant accounting period. For example, if an accounting team is compiling a report on the revenue earned within a quarter, the report must focus only on that exact period. This is intended to prevent any possibility of fudging numbers or data across time—e.g., if a company earns more one quarter than the next, the accountant must truthfully represent this fact instead of changing the period dates or altering the data to hide or reduce the difference.
9. Principle of Materiality
Accountants must, to the best of their abilities, fully and clearly disclose all the available financial data of the company. They are obligated to acquire this information from the business, which is why an accounting team’s requests may seem intensely thorough when requesting financial information.
10. Principle of Utmost Good Faith
Any person or party involved in, or responsible for, the financial side of a business must be honest in all reports and transactions. Along with several other principles, this serves to maintain an ethical standard and responsibility in all financial dealings.
4 Constraints of GAAP
Besides the ten principles listed above, GAAP also describes four constraints that must be recognized and followed when preparing financial statements.
Any financial statement must accurately reflect all of the company’s assets, expenses, liabilities and other financial commitments. Reports must therefore be thorough and clear, without any omissions or modifications.
Financial statements must be prepared in a way that follows and meets GAAP standards. Accountants in particular should be familiar with the ten key principles. Although exact GAAP requirements may vary depending on the industry, it is necessary to adhere to the principles at all times.
Every report must include the following: an income statement, a cash flow statement, a balance sheet and a statement of ownership or shareholder’s equity. The lack of one or more of these documents could trigger external audits or investigations.
If there is any additional or relevant information needed to understand the financial reports, it must be fully disclosed in the notes, footnotes or description of the report.
Following GAAP guidelines and being GAAP compliant is an essential responsibility of any publicly traded U.S. company. Though it can seem like a daunting and time-consuming process to prepare GAAP-compliant financial statements, the burden can be significantly decreased by making sound financial decisions such as hiring trained accountants and investing in reliable accounting software and bookkeeping services. Reliable and accurate information in financial statements is crucial for the well-being of all – the shareholders, investors and economy.